Speech
The Financial Stability Role of Central Banks

I have chosen as my subject today the financial stability role of central banks.

One of the consequences of the recent financial crisis has been a rediscovery,
or at least a renewed appreciation, of that role. If we think back to the pre-crisis
period, it seems fair to say that most of the public attention given to central
banking was focused on the conventional monetary policy function – that is,
the regular adjustment of interest rates for inflation control.

Without in any way diminishing the importance of that function, it is certainly
the case that the financial stability role of central banks has increased in
prominence since the crisis. We can see that in several ways. Central banks
played a crucial part in the initial crisis response by providing emergency
liquidity support to institutions and markets under strain. In many cases they
held direct regulatory responsibilities for dealing with troubled institutions,
or else cooperated closely with the agencies exercising those powers. And they
have played a key advisory role in helping to shape the post-crisis regulatory
environment around the world. During this period, governments in a number of
jurisdictions have taken steps to strengthen the financial stability mandates
of their central banks and in some cases have given them additional regulatory
powers to that end.

One commentator has gone so far as to say that the financial stability role
of central banks has been rediscovered with a vengeance[1].
I want to explore today what that might mean in practice.

The first point to make is that the financial stability role of central banks
is not new. In his book The Evolution of Central Banks[2]
Charles Goodhart argues that financial stability was an original core function
of central banks, arising from their unique position as lenders of last resort
to the banking system.

It is worth focusing briefly on the economic rationale for that role. It derives
from the nature of banking itself. Banks are intermediaries that engage in
credit evaluation and maturity transformation in order to link borrowers and
lenders. In doing so they perform a function that has become vital to the modern
economy, but the history of banking shows that, without proper supporting arrangements,
the system can be vulnerable to instability. One source of instability that
became evident as banking systems developed was their vulnerability to runs
and panics. Put simply, even a sound bank could be put at risk if it were forced
to liquidate its assets in a panic, and the best defence against that was to
give them access to a central source of liquidity[3].
Central banks evolved, or were established by governments, to meet that need.

Historically this role had important synergies with other central banking functions,
and with other aspects of what we now call financial stability policy. Under
the gold standard, the lender of last resort (and the related liquidity management)
functions were closely intertwined with the price stability objective. The
gold standard was seen as a general discipline against inflation or deflation.
Central banking actions to preserve the gold standard were therefore seen as
both promoting price stability and also promoting the capacity of banks to
meet their obligations – in other words, financial stability.

Part of that general role involved managing monetary systems in a way that would
reduce the risk of panic and instability in the first place. But it also meant
applying Bagehot's famous principle that central banks should lend freely,
at a penalty rate and on good collateral, in the event that a crisis occurred.
The liquidity management role of central banks also led naturally to their
engagement in other areas of financial stability policy, including exercising
a degree of oversight of the banks that they were lending to.

Obviously the world now is very different from what it was in Bagehot's
day. We no longer have a gold standard, and financial systems are much more
complex than they were then. But I began with that background in order to emphasise
an important point of historical continuity. Central banks retain a key role
as liquidity providers and managers today, and these functions continue to
have important synergies with other aspects of financial stability policy.

How then should we think about financial stability policy in the modern environment,
and how should we think about the central bank's role in particular? I
want to provide some general thoughts on that question while acknowledging
that this is not an area for simple answers.

When economists talk about policy frameworks in a given field, they like to
think in terms of a taxonomy that has (at least) the following main elements:

First, the objectives – what is the policy aiming to achieve?

Second, the instruments – what are the tools available for achieving
them?

Third, the strategy – what are the logical processes linking the instruments
to objectives?

And finally, governance – who are the decision makers, and how are they
held accountable?

In the case of the monetary policy function of central banks these questions
have been well studied, and there is by now a well-established consensus as
to what constitutes a best practice framework, at least in general outline.
It could be summarised as follows:

The objective is inflation control, possibly defined as a numerical target
and possibly broadened to incorporate some element of business cycle stabilisation.

The strategy could be modelled as something like what economists refer to as
a ‘forward-looking Taylor rule’. This essentially says that the
interest rate is adjusted to lean against fluctuations in output and inflation,
in order to exert a stabilising influence on both.

And the governance structure should involve the government setting the objective
and an independent central bank controlling the policy instrument, subject
to appropriate accountability.

Obviously this summary glosses over a vast amount of detail, but in concept
at least the framework is reasonably well studied and well accepted.

For financial stability policy, the position is much more complex.

The objective might be defined as something like avoid financial instability,
or perhaps slightly more scientifically, keep the risk of system-wide financial disruption acceptably low.
These things of course can't be readily quantified, at least at the level
of the system as a whole. There is no simple measure of system-wide financial
risk, and the concept certainly can't be expressed as a numerical target
in the way that can be done for the inflation objective. That doesn't mean,
however, that the task is hopeless. We are better, I think, at identifying
particular sources of risk, like excessive leverage, poor credit standards,
or leveraged asset booms, than we are at aggregating them or quantifying their
likely systemic impacts. We do know financial instability when we see it, and
we have a good idea of the kinds of behaviour that can contribute to it. The
objective, then, is to manage these risks to an acceptable level.

The second element is the set of policy instruments. Here again, the position is much more complicated
than it is for the inflation targeting framework. The potential instruments
of financial stability policy are many and varied. One component I have already
mentioned: the central bank's role in liquidity management. Other instruments
include the range of regulatory requirements that influence risk taking in
the financial sector, like capital and liquidity standards. These are what
might be termed ‘structural’ prudential instruments aimed at promoting
a generally robust financial system. In addition there is a growing interest
in the potential use of ‘macro-prudential’ tools in a time-varying
and targeted way to respond to risks as they evolve. Examples that feature
in international debate include things like maximum loan-to-valuation ratios
that might be targeted at cycles in property lending, or the counter-cyclical
capital buffer incorporated in the Basel III standards, aimed at general credit
cycles. In addition to all this must be added the capacity of prudential supervisors
to influence and respond to banks' risk taking without the use of prescriptive
rules. In Australia's case I think we have been well served by APRA taking
a pro-active approach on this front to ensure that risks in the banking sector
have been well understood and well managed. I think of this as a policy ‘instrument’
in my general schematic outline, but it is not one that can be easily quantified
or formalised.

The third element of my outline is the strategy. How are the instruments deployed to meet the objective?

It should be clear from what I have said so far that the policy strategy in
this area can never be as tightly defined or modelled as it might be in the
monetary policy sphere[5].
No one would seriously think of trying to use the equivalent of a Taylor rule
to summarise financial stability policy. But clearly the policy approach needs
to include at least the following components:

Appropriate management of system liquidity, including a framework for providing
emergency liquidity in a crisis.

Sound risk controls for other systemically important institutions, including
providers of critical financial infrastructure.

Robust crisis resolution frameworks.

Ongoing monitoring and analysis of systemic risks, including in asset and credit
markets; and

Appropriate coordination among the key policy makers.

Central banks and supervisors have been working to strengthen all of these elements
since the crisis. Internationally, there are clear benefits to collective effort
in a number of these areas. In the area of bank regulation, for example, countries
have a mutual interest in the development of common minimum standards to promote
resilience for the global system as a whole. The Basel III package of capital
and liquidity standards represents a major outcome of that cooperative effort[6].

That brief outline might be thought of as capturing some important commonalities
in the way various countries are approaching financial stability policy in
the wake of the crisis. But there are also some significant differences in
national approaches, especially in an organisational sense.

That brings me to the fourth element of my outline, which is that of governance or, put simply: who controls the instruments?

I have already made the point that one part of the instrument set – the
management of financial system liquidity, or the last resort lending function
– is inherently a function of the central bank. Internationally, one
of the areas of recent debate has been on the extent to which this and other
central banking functions should be combined with prudential regulation, or
whether they are best kept separate. And, if they are not combined, how can
they best be coordinated, given the synergies between them?

In current international practice there are a variety of different approaches
to this question. Australia of course is a jurisdiction that has an integrated
prudential regulator separate from the central bank. Other examples of that
structure are Canada and Japan. The United States and Europe have complex arrangements
that fall somewhere in the middle. The UK has just completed a transfer of
the prudential regulation function back into the central bank after separating
them in the late 1990s. Indonesia is in the process of shifting in the opposite
direction. So clearly there are a variety of different organisational models.
In many cases, including Australia, central banks have a general mandate to
use their powers to promote financial stability, even if they are not the primary
bank supervisor.

A key consideration in all of this is the obvious synergy between central banking
activities, prudential regulation, and crisis management and resolution responsibilities.
The position of central banks in financial markets is likely to give them early
visibility of many types of financial stress, and their position as the system
liquidity provider gives them an essential role in crisis management. For these
and other reasons there is a clear need for ongoing coordination of these various
roles. But coordination is not necessarily best achieved by organisational
unity. Arguments can be advanced for a range of different institutional structures,
and it is perhaps not surprising that countries have come to differing conclusions,
depending in part on their own histories and their experiences during the crisis.

With that general background, I want to conclude with some observations about
how we organise these things in Australia[7].
In particular, to come back to my original focal point, I want to ask what
is the role of the Reserve Bank in Australia's financial stability arrangements.

It is sometimes said in answering that question that the Bank is the macro-prudential
authority in Australia and APRA is the micro-prudential authority. The implication
is that the Bank looks at stability from the point of view of the system while
APRA looks only at the individual institutions. I think that is at best an
oversimplification and is an unhelpful way to look at the two institutional
roles. It presupposes that it is possible to focus on the system as a whole
without taking an interest in the individual components; or, conversely, that
an agency can sensibly look at the parts without being interested in how they
interact with the whole[8].

The difference between the two roles, I suggest, is best understood in terms
of their powers and responsibilities rather than their objectives. APRA has
powers and responsibilities that relate mainly to individual institutions,
but its legislative mandate includes stability of the system, and it can adjust
its prudential settings to address system-wide concerns. The Bank has a broad
financial stability mandate, existing in conjunction with other macroeconomic
objectives and attached to a very different set of powers.

In a legal sense the Bank is authorised to provide financial services to the
government and to the financial system, and has significant powers to engage
in financial activities in the public interest. As I have said, those powers
enable the Bank to act as lender of last resort and liquidity manager for the
financial system in addition to its better-known role in conducting monetary
policy.

When bank supervisory powers were shifted from the Reserve Bank to APRA under
the 1998 Wallis reforms, the Bank's general mandate to use its powers to
promote financial stability was reaffirmed. This was more recently emphasised
by the incorporation of reference to the financial stability mandate into the
Statement on the Conduct of Monetary Policy in 2010. The Wallis reforms and
subsequent legislative changes also gave the Bank significant regulatory powers
in relation to the resilience of the payments system and of financial market
infrastructure.

In summary, then, the Reserve Bank and APRA have different powers but overlapping
and complementary objectives in relation to financial stability.

It goes without saying that the two institutions have a strong appreciation
of the need to work closely together and to coordinate with the other key agencies,
especially ASIC and the Australian Treasury. There are a number of mechanisms,
both formal and informal, for achieving this. At the peak level the four agencies
form the Council of Financial Regulators, chaired by the Reserve Bank Governor.
Numerous other coordinating arrangements exist at the staff level. Although
the Council is a body without formal powers, it has played an important role
in a number of different ways, including information sharing, helping to develop
the overall post-crisis response and in making coordinated recommendations
to the government. Internationally I find that there is a lot of interest in
the Australian coordination arrangements, and it is interesting to observe
that a number of other jurisdictions have moved to develop financial stability
council structures of their own in the wake of the crisis.

To recap briefly, I have tried to outline what I see as the main elements of
financial stability policy, to explain why the central bank has a key part
in it, arising from its role as system liquidity manager, and to highlight
the need for coordination between the central bank and other agencies, especially
the prudential regulator.

All of that falls well short of a general theory of financial stability, unavoidably
so because I don't think such a theory is achievable. Nonetheless, I think
the arrangements that I've just described have generally served Australia
well. During the recent period of global financial stress, our banking system
and our crisis management arrangements have proved more resilient than most.

In the end, of course, what counts is not the way financial stability policies
are allocated to particular agencies but the quality of their implementation.
And that of course remains the focus for the Reserve Bank, as well as for the
wider body of financial regulators in Australia and abroad.

Endnotes

Buiter (2012), The role of central banks in financial stability: how has it changed?
CEPR Discussion Paper Series No. 8780.
[1]

Goodhart (1988), The Evolution of Central Banks, MIT Press. For a more recent discussion,
see Goodhart (2010), The Changing Role of Central Banks, BIS working paper
326, <http://www.bis.org/publ/work326.pdf>
[2]

By this I mean a last line of defence. I don't mean to imply that banks should
not hold liquid resources of their own in the first instance.
[3]

I leave aside here the question of ‘unconventional’ measures when interest
rates are at or near zero.
[4]

Arguably most fields of public policy are unlike monetary policy in this sense.
[5]

Other examples include common mortgage underwriting principles, and the development
of regulatory standards and resolution regimes for critical financial market
infrastructure.
[6]

For a comprehensive discussion of financial stability arrangements in Australia,
see the joint RBA and APRA document Macroprudential Analysis and Policy in
the Australian Financial Stability Framework, <http://www.apra.gov.au/AboutAPRA/Publications/Documents/2012-09-map-aus-fsf.pdf>
[7]